Saturday, May 19, 2012

Macro 'policy mix' returns to normal

In case you missed it, the secretary to the Treasury has spelt it out: with the budget's planned return to surplus next financial year, fiscal policy is being put back in the cupboard and the "policy mix" returned to normal.

Delivering his annual post-budget speech to the Australian Business Economists, Martin Parkinson outlined the "macro-economic framework" - the respective roles of fiscal policy (the manipulation of government spending and taxation), monetary policy (the manipulation of interest rates by the Reserve Bank) and the exchange rate.

"The primary responsibility for managing demand to keep the economy on a stable growth path consistent with low inflation" had been allocated to monetary policy, he said.

So "normal" is for monetary policy to be doing most of the work in keeping the economy steady. Its aim is "to maintain inflation between 2 and 3 per cent, on average, over the cycle". But, as you see, this doesn't mean the Reserve focuses on inflation to the exclusion of all else.

While keeping inflation low may be the target, the goal is non-inflationary growth - growth which should keep unemployment low.

And a key part of the mechanism for achieving low inflation and steady, job-creating growth is, in Dr Parkinson's words, "anchoring inflation expectations". Because the expectations of wage negotiators and businesses tend to influence the demands they make and the prices they set, keeping them expecting inflation to remain low is half the battle.

That's one of the main roles of the inflation target. Provided people are confident the Reserve will stick to its target - as they are - you can allow the economy to grow at a faster rate than otherwise.

Parkinson linked monetary policy with the exchange rate. "Monetary policy is supported by a floating exchange rate, which acts as a shock absorber that offsets some of the effects of global shocks on the economy and naturally adjusts in response to other economic developments," he said.

When, for instance, world commodity prices rise a lot and our terms of trade improve, the dollar tends to rise.

The extra national income flowing from the higher export prices would lead to a surge in demand that could be inflationary (and, in the days when our exchange rate was fixed, it was). But the higher exchange rate reduces the international price competitiveness of our export and import-competing industries which, by reducing exports and increasing imports, reduces the external component of aggregate demand (gross domestic product).

And this, combined with the direct reduction in the prices of imports, helps keep inflation under control. The exchange rate has thus absorbed some of the shock from the rise in commodity prices and so kept the economy growing steadily. When commodity prices fall, the process works in reverse.

But if monetary policy is the main policy instrument used to keep the economy on an even keel, what is fiscal policy's role?

Parkinson says a key objective of fiscal policy is "to maintain fiscal stability from a medium-term perspective". That is, to ensure we don't run so many budget deficits that, in time, we build up a level of government debt that becomes unsustainable.

(To see what nasty things can happen when you don't "maintain fiscal stability" look no further than Greece, with Italy and other European economies heading down the same track.)

But this is Parko's key message: "Outside of the automatic stabilisers, discretionary fiscal policy should only be used for supporting demand during extreme circumstances, such as when: the effectiveness of monetary policy is impeded; and/or a shock is sufficiently large and sufficiently sudden that monetary and fiscal policy should work together to support activity, such as during the global financial crisis."

Let's unpack that mouthful. As we saw here last weekend, the budget contains "automatic stabilisers" that cause the budget balance to deteriorate when the economy turns down and improve when the economy turns up.

So the budget acts automatically to help stabilise the economy as it moves through the business cycle, with public sector demand expanding automatically at times when private sector demand is weak, and contracting automatically when private demand is strong.

Parkinson is saying this is a good thing and the macro framework requires that the automatic stabilisers be unimpeded in doing their job. That is, governments shouldn't take explicit ("discretionary") decisions that counter the effect of the stabilisers.

(Attempting to counter the stabilisers is exactly what the Brits and other Europeans are doing with their "austerity" policies. They've been slashing government spending at a time when the economy is weak. This weakens demand further, pushing the economy back into recession and, far from reducing the budget deficit, makes it worse. By ignoring elementary Keynesian principles, they've blundered into an adverse feedback loop.)

The next element in Parkinson's exposition of fiscal policy's role in the macro framework is that governments may take discretionary measures that reinforce the effect of the stabilisers, but only in extreme circumstances - such as a potentially serious recession.

In other words, apart from allowing the stabilisers to do their thing, it's not normal practice for fiscal policy to be used to manage the strength of demand from year to year. That's the job of monetary policy, for which it's better suited (because it can be adjusted quickly and easily and in small or large steps).

Parkinson says we've had such a "medium-term" approach to fiscal policy since the mid-1980s, "before evolving into a fully articulated framework with the development of [Peter Costello's] Charter of Budget Honesty in the second half of [the] 1980s". The charter requires the government of the day to announce a "medium-term fiscal strategy" and Wayne Swan's strategy is only marginally different from Costello's: "to achieve budget surplus, on average, over the medium term".

This formulation is carefully designed (by, I suspect, the Liberals' Senator Arthur Sinodinos) to allow the automatic stabilisers to push the budget into deficit during recessions - and even to permit governments to implement fiscal stimulus packages during recessions, as this government did - provided the stabilisers are unimpeded in returning the budget to surplus and any stimulus spending is ended.

This means that, over time, all the deficits incurred during downturns are roughly offset by all the surpluses achieved during upswings. The surpluses are used to pay off the deficits, thus keeping the level of government debt steady and sustainable over time.

So fiscal policy and monetary policy have different roles, and monetary policy and discretionary fiscal policy need to pull together only in emergencies.